Opinion: China’s Stock Connect: More boom and bust?

The trading floor at the Hong Kong Stock Exchange in a file photograph from 2014.

HONG KONG (MarketWatch) — Once dismissed as a “ghost train,” the trading scheme — known variously as the “new China through train” or Shanghai-Hong Kong Stock Connect — roared to life last week, helping send the Hang Seng Index
HSI, +0.31%
to a seven-year high.

But this awakening brings not just welcome stock gains, but also fear of a rerun of the euphoric boom and bust of 2007, when a previous through-train plan was announced, only to be later shelved. This time, a possible bust may also challenge the Hong Kong dollar’s currency peg.

Unlike the failed 2007 scheme, the new Stock Connect was designed to limit exuberant cross-border money flows, as it operates under a closed loop.

That may be easier said than done. Hong Kong holds a unique position as the first and only stop for mainland Chinese who want to buy foreign equities.

This will not be lost on global funds which may want to hitch a ride on this through train, even if it is a roller coaster.

All signs suggest the trading scheme will be extended. Hong Kong’s political leader, Chief Executive C.Y. Leung, has been quick to laud the “win-win” of deepening cooperation with Shanghai. Already, it is expected daily trading limits — 10.5 billion yuan ($1.69 billion) going south, and 13 billion yuan going north — will be expanded.

Many were caught unaware by the by speed of the post-Easter-holiday surge in southbound investment. As these quotas were filled for the first time, the benchmark Hang Seng Index finished the week up 7.9%.

One explanation for the rush south was a new insurance-investment policy, which allows Chinese mutual funds to participate in the Stock Connect. Another is an inevitable catch-up, with the A-share (Shanghai) rally spilling into H-shares (Hong Kong) as mainland investors come south to pick up bargains. (See previous column on the divergence between the two markets.)

Yet turnover figures suggest the Hang Seng Index’s surge past the 27,000 mark cannot be a result of the Stock Connect alone. On Thursday, for instance, volume reached a record 293.9 billion Hong Kong dollars ($37.9 billion), three times normal levels.

Analysts are offering different explanations for the surge. Bank of America writes that we are witnessing a “Keynes beauty contest,” in which the jump in money flows is likely driven by some investors anticipating other investors’ reaction to government policy.

This could be enough to keep southbound traffic strong in coming weeks, they argue, although adding the caveat that this is not a high-conviction call rooted in any solid fundamental analysis.

Julius Baer writes that the influx of mainland Chinese money likely means Hong Kong may again be headed for another period of “irrationality,” similar to the final few weeks of 2007 when the Hang Seng Index rose 30%.

This would mean investors in Hong Kong stocks need to consider not just the behavior of new Chinese retail investors, but also second-guess likely government policy toward the trading scheme.

The argument for having exposure to Chinese companies listed solely in Hong Kong is that the trickle of mainland money is only going to move in one direction — up. Quotas will be expanded, and more Chinese equity and commodity markets will be added to the Stock Connect.

The main driver appears to be shifts in asset allocation, as alternative investment products have been shunned due to failing interest rates, while a weak property market has also fallen out of favor as an investment.

Second-guessing policy moves from Beijing will be key. It should be remembered the Stock Connect was designed in such a way as to make it easily switched off. If fund flows circumvent China’s capital controls, Beijing may well apply the brakes.

Hong Kong also has pros and cons to consider in terms of this latest influx from the Chinese mainland.

Bourse operator Hong Kong Exchange & Clearing
0388, +0.39%HKXCF, +0.62%
is a clear beneficiary, since as the scheme expands, it should not just boost turnover but also Hong Kong’s status as a listing destination. Such listings would include Chinese companies seeking to gain access to international capital, as well as foreign firms hoping to access mainland funds.

But just how much new business and capital inflow can Hong Kong handle? Last week, the Hong Kong Monetary Authority had to intervene to stop the Hong Kong dollar from rising. It sold HK$11.31 billion of local currency on Saturday, following on from a combined HK$16.275 billion on Thursday and Friday.

The risk is that by inviting mainland money in, while at the same time maintaining a peg to the U.S. dollar, authorities are stoking a market bubble and other forms of inflation. Already, property prices are reported to have made fresh highs in February.

A potential yuan
USDCNY, -0.1972%
depreciation is another wild card. This would trigger more fund flows into assets denominated in Hong Kong dollars.

The end result could be that, if capital flows continue at the levels seen last week, we may see not just a bubble, but a runaway through train taking out the Hong Kong dollar peg.

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